Wednesday, April 24, 2013

Euro area: A few alternatives.

Many times, the private debates in which I have participated have been fueled by the debt and the banking crisis and the imminent recession. What went so uglily wrong? What should have been done? Is it too late? Can things take a turn for worse? 

Firstly, it is essential to unfold the exact chain of events the way I apprehend it based on my knowledge of economic theory. Everything began in 2007-2008 when the financial sector of the US devastating losses following the collapse of both the sub prime lending and its securitization and gradually the rest of the world was infected. After Lehman Brothers everyone realized that there was nothing to end painlessly. In their effort to prevent a broader contamination, governments borrowed large sums in other to strengthen the balance sheet of the banking and financial sector and safeguard their economies. Put differently, tax payers are asked to pay for a risk they never undertake and for which they never compensated. Nations with weaker financial and banking sector were forced to borrow yet heavily while nations that had already accumulated debt (preceding 2008) end up borrowing at an unsustainable high interest rate. Thereafter, austerity emerged as the most efficient way to address the over-indebtness with unemployment and recession being the price. The recession that was due to the austerity measures implemented in northern Europe, and to several other nations, will most likely propagate to the rest of the Euro area and then to the US and gradually to the rest of the western economies. 

Economies are highly interconnected. The demand of any given area determines the supply of other areas too, i.e exports. Economic agents being aware of this interconnection are more likely to expect the income to diminish and they will subsequently reduce their demand. he Exports of other countries fall alongside the internal absorption of their trade partners and the recession disseminates.

So, yes! Economies are about to perform much worse... Debt will then become the least of our concerns.

It has been for a long time my belief that the weaknesses of the financial and the banking sector must had and must always be addressed by the Central Banks. The reason is as simple as this: Central "Banks"! In addition, that is the only way to prevent the transformation of financial losses into public debt due by taxpayers. A Central Bank has technical knowledge and unbounded means necessary to safeguard the financial entities subject to its superintendence. Here is the plan: the Central Bank finances the equity capital increase indispensable for the bank to comply with the regulation, obtaining common stock in exchange and taking over the administration of that given bank. The loss of the rest of the share holders' suffrage and the forfeiture of administration serve as disincentives to undertake excessive risk and hence as a remedy for moral hazard. Moreover, while being in charge, the Central Bank may prevent further credit expansion, risk exposure and enlargement of the position after the amelioration of liquidity and hence may halt excessive expansion of monetary aggregates and financial market booms. Alternatively, the liquidity injected as a result of this form of bail out can be absorbed by selling the government debt the central bank disposes or by raising reserves requirements. The former risks increasing the borrowing cost of the member states but the latter has no large side effects whatsoever, yet it affects all the banks. Therefore, limiting the credit provision up to the needed extent remains the most viable sterilization tool.

All the aforementioned, could be a form of response to the 2008 challenges, the Cyprus banking crisis and to other similar crunches that may appear in the future. The scheme under which the Central bank can intervene in that way is subject to many alterations, but the financing of the balance sheets exclusively by the monetary authority is the key. For instance, ESM can be entirely financed by ECB with the latter providing unlimited funding to the former.

Please note, that obligating tax payers to cover the financial losses is like proceeding to a haircut of their savings. The present value of the future additional tax is equal to the bail out amounts needed since the rate under which government borrowing occurred is what will determine the tax increase in the future; e.g. the government will collect 110€ from taxes in two years for borrowing 100€ now, hence the taxpayers have to remove 100€ from their current income in order to have 110€ two years from now. This short of Ricardian equivalency holds, primarily because the funds allocated for regulatory capital needs have no side-impact on the economic activity outside the financial sector and because future generations will inherit the lower savings of their ancestors.

If you consider Central Banks' aggressive and extensive intervention to be absurd and unjustified, please take some minutes to think what the adjectival for bank deposits haircut would be...

Moving on to the debt crisis burst in 2009 in the EMU, the alternative would be the funding by the EMU partners of the Keynesian policies of the weaker nations- and the Keynesian tactics for their own economies- and after recovery is achieved increasing- as a result of growth- tax revenues in combination with gradual structural reforms and budget cuts in a 10 year horizon would be a more efficient mix to deal with the debt problem; provided, of course, this problem really exists. A period of 10 years is not long when profound structural adjustment is the issue. And since programme nations are about to enter yet another year, the sixth one, with either no access at all or access at a high cost to bond markets we cannot expect to receive any praise at all. On the other hand, recovery would have been strong instead, measures for current account and budget surpluses might have already begun bearing fruits, making debt repayment easier and lowering significantly borrowing cost. Additionally, intervention from the monetary authority to lower the short-term rates would have further broaden the boundaries of the expansionary fiscal policy. 

Boosting aggregate demand, stimulates investment and fuels growth. A fiscal multiplier around 1.2-1.5% and tax revenues around 30-40% of GDP (other countries are below 30% and some other above 42%, will yield some 0.4-0.6%  of GDP additional tax revenues for every 1% of GDP of budget deficit. The truth is that debt goes up by 0.4-0.6% for every 1% of deficit without taking into account the reduction of the cyclical component of government expenditure.

Last, but not least, the institutional role of the ECB and its mandate needs to be altered as soon as possible, and that is a prerequisite if we decide to change our policy orientation at last.

I you are not convinced yet, please consider what is happening at the moment. It is really worth reexamining our policy... Maybe, at the end of the day, the price of our ongoing choices  proves to be freaking high! Even worse, fighting debt with more debt and recession really needs to make the taxpayers from the non-programme-countries worry about the possibility of taking their surpluses back...